Hedging Strategies for Uncertain Times

An overview

It is important to understand the nature of alternative investment strategies and their risks before considering any action.

The following article describes the concept of hedge funds/alternative investments, many of the different strategies they employ, and their relationship to Modern Portfolio Theory. The next issue of the Graziadio Business Review will include a companion article that will consider alternative investments or hedge funds as an option for individual “Main Street” investors, including a look at the idea of a fund of funds and the construction of such a “fund” utilizing mutual funds. The Editors.

The name was famous — Sir John Templeton — a name synonymous with investment results and investment prudence. When Sir John recently revealed in the Financial Times that he was partially hedging his equity investments, it raised the question for many of whether other investors should follow his lead and partially hedge their investments as well. Along with other investment stars such as Warren Buffet and Sidney Glickenhaus, Templeton believes that the long bull market is over. None of them is forecasting doom, although Buffet is looking for a modest 7% total annual return with increased volatility, and Glickenhaus believes that after a sixteen year cycle of boom, we could possibly see a sixteen year cycle of readjustment.

This outlook, perhaps one of irrational pessimism, is interfacing with an increased belief of many investors that a bubble is about to burst. It is not clear what bubble is meant. The explosion could come from the Treasury market, the stock market, one of the bond markets, or the housing or mortgage market. There appears to be no end of possible financial crises. There is also the underlying fear of yet another 9-11 type incident.

Hedging As an Option

It is not surprising then that many Main Street investors want to hedge a part, if not all, of their investment portfolios. They have heard that hedging can create high returns in both good and bad markets. However, the important point to remember is that high returns come only at the expense of high risk.

In the classical sense, hedging is an attempt to earn a riskless return. An example of this would be to short futures on the Dow Jones Industrials and go long on the underlying Dow Jones Industrial stocks in the cash market under certain pricing characteristics. To do so would create a true arbitrage-hedged portfolio, which if positioned correctly, could yield a riskless return. Unfortunately, a riskless return centers on T-bill interest. This return is indeed free money, but not the rate most investors desire. Hence, there is a tendency to move toward more risky hedge funds.

Fund Performance History

The performance of hedge funds has been good enough to continue to attract attention by investors. A recent article in Barron’s dated July 28, 2003, reported on the performance of hedge funds and noted that during the twelve month period ended June 30, 2003, 80% of hedge funds tracked by CISDM did better than the 1.5% decline in the S&P 500 index. Over the three-year period ended June 30, 2003, the article reported that 97.4% of the hedge funds had better results than the 32.9% decline in the index. This very solid performance gives hedge funds a powerful attraction as an alternate investment for investors.

However, it was further noted that during the April-June 2003 period, with the S & P 500 index up 12.9%, only 137 funds–or 20%–outperformed the index. This poorer performance makes hedge funds seem less advantageous as an alternative investment, although this example covers a very limited time period. Numerous individuals have pointed out that in general hedge funds are far more powerful in a down market than in an up market. However, this is not necessarily the case when one reviews the many different categories of so-called hedge funds available to an investor today.

Hedge Funds Defined

The vast majority of what are called hedge funds today do not conduct classical investment hedge strategies. In fact, it should be noted that the hedge fund industry is itself trying to change the nomenclature from hedge funds to alternative investments. This is clearly a better terminology than the one now in use. One should soon see this title being employed with increasing regularity.

Currently, however, the more common term is “hedge fund.” A hedge fund is nothing more than an unregulated investment pool (not under Securities and Exchange Commission review) with no more than 99 accredited investors (one million in net worth, or $200,000 in income) doing “something.” It is estimated that there are well over 5,000 so-called hedge funds in the United States with almost $400 billion in assets. Clearly this is an investment alternative that cannot be ignored.

Investment activities of these funds are conducted using a number of investment strategies. There is no general consensus as to their investment definitions. However, some fourteen categories of strategies have been suggested. Within each category, there are considerable differences in style and objectives. Particular categories could be combined with others, and often are, for computation of results. Further, there are considerable differences in the amount of leverage (borrowed money) that is employed. One must therefore review carefully the characteristics of the hedge funds included in any category results. The fourteen categories are described below.

Hedging Categories

1. Dedicated Short Bias

This is a so-called “bear” strategy wherein the fund is continuously shorting stocks it does not own in anticipation of a decline in value. The fund will perform inversely to the market. Therefore, these hedge funds will have extreme results. If the market is going down, the funds will have very high positive returns. However, if the market goes up, they will have very high negative returns.

2. Value Long/Short Equity

This strategy is an attempt to short stocks perceived to be “overvalued” and to purchase stocks perceived to be “undervalued.” The beta of the portfolio is allowed to vary depending on the economic outlook, although a low positive beta is the norm. One could approximate the market return if the portfolio selection were outstanding. (Beta is a measure of the sensitivity of the portfolio to the S&P 500 index, which by definition has a beta of 1.00.)

3. Market Neutral Equity

This strategy is the classical equity hedge. Here the attempt is to be insensitive to the market and create a portfolio with a beta of zero at all times. A second objective is to significantly outperform the T-bill rate by some multiple. Many times this strategy is combined with the value long/short equity due to the similarities of the two strategies.

4. Market Neutral Arbitrage

This strategy involves being long and short by approximately the same dollar amounts utilizing arbitrage techniques. Convertible bond arbitrage is an example of this strategy. In this strategy the fund sells short the common stock of a particular company while going long on the convertible bonds of that same company under proper pricing characteristics. Many consider this an excellent type of a hedge with modest risk if properly executed. The difficulty is finding enough opportunities in a rather limited market without resorting to more risky subsets. Likewise, fixed income arbitrage is often included within this category.

5. Fixed Income Arbitrage

This strategy is an attempt to use the bond market in a variety of different strategies. One could sell short the bonds of a company perceived as likely to have its credit downgraded and buy bonds of a company perceived as likely to have its credit upgraded. One could also short bonds of higher credit companies and use the proceeds to buy bonds of lower credit companies in anticipation that the Bond Confidence Index will move towards 100 as it has recently done. In this situation, lower quality bonds will do much better than higher quality bonds.

6. Managed Futures

This strategy uses the futures market to construct a variety of transactions. This is clearly a speculative strategy inasmuch as one can borrow considerable funds to leverage big plays.

7. Emerging Markets

This strategy uses the international markets (usually stock) to engage in speculative behavior. It normally centers on shifting funds from one foreign emerging market to another. Since these markets have high volatility and wide directional swings, there are considerable money-making possibilities. One can guess wrong as well. For example, many funds purchased Russian government bonds because of their high yield just prior to the government’s defaulting on them.

8. Macro

This strategy centers on “a top-down approach” more than anything else, with an intermediate time frame that is normally less than a year. Less emphasis is placed on individual financial assets than on a broad category of financial assets. George Soros often has bet on currency fluctuations. The recent deterioration of the U.S. dollar versus the euro is a good example of this strategy because it gave significant profits to speculators who anticipated the exchange rate change correctly.

9. Event Driven or Special Situations

This strategy can cover a very wide number of activities. A modest risk example would involve purchasing shares in companies re-purchasing their own common stock on the open market. Another example would be to purchase shares in companies increasing their dividends because of the recent change in taxation. A more risky example would be engaging in arbitrage in companies involved in mergers. A much higher risk example would have been to buy shares in Union Carbide (just after the accident that unfortunately caused a high death toll at the chemical factory in Bhopal, India) on the belief that the market “overreacted” (at least financially) to the news. Finally, many would place the purchase of distressed (usually bankrupt) securities within this category.

10. Market Timing

The market timing strategy is conceptually quite simple. It is clearly short-term in nature and usually based on technical factors such as price, volume, or behavioral sentiment. The objective is to buy a particular financial asset such as the S&P 500, perhaps even heavily leveraged, with the anticipation that the asset will increase in value. Needless to say, the reverse is adopted when assets are anticipated to decline in value. Sector rotation would also be included as a sub-set within this category. Sector rotation involves switching among Fidelity-like industry-specific sectors based upon either financial or technical characteristics.

11. Sector Specific

This strategy is different from sector rotation. Here more emphasis is placed within an industry-specific sector, perhaps selling “overvalued” stocks and buying “undervalued” stocks. The two most popular categories appear to be technology and financial services. Other industry categories are also utilized. Indeed, any Fidelity-like sector could be utilized.

12. Opportunistic

This strategy involves a fund manager rotating among the above strategies dependant upon the outlook associated with the chosen strategy at a particular point in time. This strategy category, more than any other category, depends on the investment judgment call of the portfolio manager.

13. Aggressive Growth

This strategy centers on investing in stocks that have a high growth potential due to strong sales and/or earnings growth. An example is a sales momentum model wherein one looks at the trend of annualized sales increases. Standardized Unexpected Earnings (SUE) is another example. SUE involves buying/selling (or shorting) stocks in companies that have reported earnings above/below the statistical estimated deviation or above/below the statistical deviation from analysts’ estimates.

14. Other strategies

Anything one can think up involving a financial asset can be put into play. Indeed, one of the fastest growing alternative investment categories has not been reviewed in this paper. This is the Fund of Funds category. As the name indicates, this is in essence a (diversified) portfolio of different alternative investment (hedge fund) strategies. (The Fund of Funds category will be addressed in the second article in this series.)

Hedge Fund Results

It is not surprising, given the multitude of categories and styles of hedge funds, that the financial results are quite mixed and involve extreme ranges of performance. Since these hedge funds have performance incentive fees for fund managers, it is also not surprising that they have attracted a lot of qualified talent. Unfortunately, they have attracted a lot of con artists as well, not to mention a good number of failed stockbrokers who, unable to find other employment, have become “Hedge Fund Managers.” Hedge funds are the investment community’s equivalent of the Internet. One must seek out the “best play” among a wide number of funds, many of which are headed for listing in the potential web site “www.hedgefunds.bombs.” However, a good number of hedge funds will be listed in the potential web site “www.hedgefunds.winners.”

The fact that so many hedge funds have come and gone creates a statistical nightmare for financial evaluation due in part to survivorship bias. Compounding this difficulty in evaluating performance is the fact that some managers will terminate a losing hedge fund only to start up a new one in hopes of a better record!

Hedge Funds and Modern Portfolio Theory

Even sophisticated investment managers and consultants utilizing all of the Modern Portfolio Theory (MPT) tools confess to being frustrated with trying to understand and properly quantify the risk-return matrix of many of the hedge funds. The calculations are not difficult, but the statistics can be almost totally meaningless. This would be the case, for example, when the calculations are applied to an opportunistic-style fund manager. There is no reason to assume that the past has any significance or predicative power for the future in such a situation.

Modern Portfolio Theory, on the other hand, assumes a high likelihood of the re-occurrence of investment risk and outcome. For example, MPT shows there is a high probability that over a ten-year period small-cap stocks will outperform large-cap stocks, which in turn will outperform corporate bonds, which will outperform government bonds, which will outperform T-bills, which will outperform inflation. This kind of probability does not exist with hedge funds. There is no basis for believing in the existence of any reliable rank order. Any rank order is extremely time-dependent. A good number of these funds involve the exploitation of an investment anomaly or are based on a hunch. Anomalies and hunches can never be properly quantified. Hence, one must be cautious about the rank order of a manager within a category over the long-term. One buys the manger and hopes that the historical (favorable) risk-reward relationship will continue.

Buying the manager, as we well know, can be a disaster. Long-Term Capital (LTC) was a hedge fund with tremendous capability and resources. Funded by well-known names, as well as Wall Street brokerage money, LTC employed the very best, including Nobel Laureates with Ph.D.s in finance! LTC had many favorable MPT characteristics. However, even with all of this talent, knowledge and intellect, LTC created one of the greatest investment disasters of all times. It suffered losses so great that the Federal Reserve was afraid that LTC’s failure could severely hurt the entire financial market as a result of its multiple trades that were yet to be unwound. To avoid a financial meltdown, the FED rushed to provide the liquidity required. (The LTC hedge fund receives first place in hedgefunds.bombs.)

One key advantage of Modern Portfolio Theory is the concept of mean variance analysis. This concept centers on the reward (return) per unit of risk borne (standard deviation).

Table 1 shows particular MPT statistics for a group of hedge funds that are representative of the strategies listed above, although the categories are not an exact match. The statistics cover a fifteen-year period ending in 2002. For comparison, these funds’ performance relative to the performance of the S&P 500 over this period is also included.

Table 1: Relative Hedge Fund Performance
1988-2002

Category

Average Return %

Std Deviation

Sharpe Ratio

S & P Relative %

Aggressive Growth

18.3

18.3

0.9

129

Distressed

10.5

4.8

1.5

214

Emerging Markets

20.5

22.8

0.9

129

Income

11.8

4.7

2.1

300

Macro

18.0

15.4

1.1

157

Market Neutral – Arbitrage

4.9

5.8

2.2

314

Market Neutral – Securities

17.8

5.2

2.9

414

Market Timing

18.9

12.7

1.3

186

Opportunistic

21.1

12.9

1.4

200

Short Selling

5.1

22.9

0.3

43

Special Situations

18.4

9.3

1.7

243

Value

18.0

12.9

1.2

171

Van US Hedge Index

17.7

9.4

1.6

229

S & P 500

11.5

15.5

0.7

100

1) The Sharpe Ratio is the best-known Modern Portfolio Theory statistic. It is the return of the portfolio minus the risk-free rate divided by the standard deviation.
2) Data on US hedge funds are from Van Hedge Funds Advisors, Inc., one of the major advisors within the hedge fund industry.

Conclusion

The alternative investment phenomenon is of importance to investors. The fifteen-year result of all U.S. Hedge Funds as noted by the Van Hedge Index is impressive at 229% relative to the performance of the S&P 500. Investors are forced to take note due to this performance. Alternative investments are clearly far more difficult to comprehend and analyze than perhaps any other form of investment. They are, however, clearly appropriate for certain individuals as part of their investment portfolios.

About the Author(s)

Darrol J. Stanley, DBA, is a professor of finance at the Graziadio School of Business and Management. He is well-known as a financial consultant with special emphasis on valuing corporations for a variety of purposes. He has also rendered fairness opinions on many financial transactions, and he has been engaged by corporations to develop strategies to enhance their value. He has served as head of corporate finance, research, and trading of four NYSE member firms. He likewise has been the principal of an SEC-registered investment advisor. He has completed global assignments as well as having served as Chief Appraiser of International Valuations/Standard & Poor's in Europe, Central Europe, and Russia.